Federal Reserve Keeping Interest Rates Low – What It Means

Federal Reserve Chairman Ben Bernanke said last week on Wednesday that the Fed intended to hold short-term interest rates near zero “at least through late 2014”. The late 2014 timeframe for the first rate hike was considerably later than investors had expected and about 18 months later than the Fed had suggested last year. The extended period reflects the Fed’s concern about continued “significant downside risks” that would impact the economy. Some of the primary factors influencing the Fed’s decision were the high unemployment rate, slow economic growth, the depressed housing market and the economic and debt problems in Europe. The Fed does not expect a complete economic recovery during the next three years.

Forecasters are anticipating that the U.S. economy will have slower growth in 2012, expecting around a 2 percent growth rate. This growth rate is not enough to significantly reduce the unemployment level. By keeping rates near zero, the Fed hopes that the low cost of borrowing will drive economic growth and in turn will reduce the unemployment rate. However, up to this point, the Fed’s policy of low interest rates has been insufficient to bring unemployment down to levels considered normal during good economic times. As with most statistics, it’s important to “dig” into the numbers to get a better understanding of what is occurring. For example, a portion of the declining unemployment rate is a result of baby boomers retiring and people who have stopped looking for work. Thus, a declining unemployment rate doesn’t necessarily reflect an improving economy.

Bernanke said the central bank was ready to offer the economy additional stimulus and left the door open for the Fed to purchase more bonds, which would provide an influx of money into the market. Some Fed officials have suggested that the Fed should buy mortgage-backed securities, as it did in 2009, to reduce interest rates on mortgage loans further. Although mortgage loans are at record lows, this has not stimulated the housing market as most loans being completed are by home owners refinancing as opposed to new homeowners buying. Additionally, millions of homeowners continue to face foreclosure.

Implications of low interest rates:

- Interest rates on savings account, money markets and CDs will continue to be minimal. Cash investments, while safe from losing in value, will not keep up with the rate of inflation, thus will be able to buy less.

- The announcement prompted a rally in U.S. government bonds. However, once interest rates do begin to rise (or are expected to begin to rise), bonds will decrease in value.

- Gold prices rose and the dollar dropped with the expectation of continued slow economic growth and the possibility of additional government debt.

- Interest on our national debt will continue to be “low”; however, once interest rates rise, the debt level will increase as the interest payments become larger.

Considerations:

- Pay down variable rate loans while the rates are low so that more of your payment goes toward the principal.

- Look into refinancing your mortgage or rolling other loans, such as credit cards, student loans, car payments, etc. into your mortgage so that you lock in a low rate and can write off the interest portion on your tax return.

- Yes, cash is safe, but it’s not earning much. For cash in excess of your emergency fund or targeted for short-term goals, we should discuss other investments options.

Please contact me if you’d like to review your current situation and to discuss what financial actions might be appropriate for you.